Investing in real estate used to be only possible for super-wealthy investors or institutions. That is, until Real Estate Investment Trusts, or REITs, were created. Designed to make real estate investing more accessible, REITs give small investors access to the benefits of a diversified and professionally managed real estate portfolio.
What is a REIT?
REITs allow investors to own real estate without the challenges of property management. They are companies that own, finance, and, to a certain extent, develop income-producing real estate across various property sectors. While many REITs specialize in a specific property type, such as commercial buildings, apartment complexes, hospitals, or shopping centers, others diversify by holding multiple properties.
How does a REIT work?
In Canada, REITs are structured as trusts (the structure in the U.S. is slightly different) that pool investors’ money to purchase and manage income-generating properties. REITs generate income through collecting rents, capital gains from property sales, or mortgage interest. This income is then distributed to unitholders (beneficiaries) as distributions.
There are numerous requirements for a company to qualify as a REIT. In most countries, REITs are required to:
- Distribute at least 90%–100% of their taxable income to unitholders as distributions.
- Invest at least 75% of their assets in real estate and
- Derive at least 75% of income from real estate rental income or mortgage interest.
There are several REIT types, including equity REITs, mortgage REITs, and hybrid REITs. Equity REITs invest in and own real estate, while mortgage REITs provide real estate financing by originating or purchasing mortgages or mortgage-backed securities. Hybrid REITs combine equity REITs and mortgage REITs.
What are the advantages of REITs?
- Potential for Stable Income: One of the most attractive aspects of REITs is their potential for consistent income. They often offer attractive yields since they distribute a significant portion of their income to unitholders. Typically, Canadian REITS pay monthly distributions, while American REITs offer quarterly distributions.
- Tax-Efficiency: REITs are structured as trusts, meaning they are not taxed at the ‘corporate’ level on real estate income if distributed to unitholders. This allows more income to flow directly to investors, who then pay taxes on the distributions received.
- Liquidity: Most REITs trade on public exchanges, offering liquidity that allows investors to purchase and sell units in nearly any dollar amount. In contrast to direct real estate investments, which often demand a significant initial investment, REITs allow investors to choose smaller investment sizes.
- Transparency: If the REITs are publicly traded, they also offer transparency with readily available unit prices and transaction histories.
- Diversification: Another advantage of REITs is that they provide investors with diversification benefits. They offer exposure to real estate assets across various sectors and geographic locations, reducing the risk of investing in a single property or location.
- High-Quality Real Estate Portfolios: They typically hold high-quality portfolios with assets in leading markets.
- Active Professional Management: Finally, REITs benefit from active professional management, with strong executive oversight and dedicated property management teams, often leveraging economies of scale.
What are some risks involved in investing in REITs?
- Market Sensitivity: REIT performance is closely linked to an ability to generate income. During economic downturns, rental income and real estate occupancy levels tend to decline, reducing earnings and property values.
- Interest Rate Fluctuations: Moreover, rising interest rates can sometimes drive down demand, leading to lower property values and possibly lower unit prices.
- Lack of Retained Earnings: Since REITs must pay out at least 90% to 100% of their earnings to their unitholders as distributions, REITs will need to access capital markets to fund their expansion and growth, which can also impact the unit price.
- Tax Implications: While REITs are tax-efficient for investors, there are still tax considerations to be aware of. REIT distributions are not the same as dividends from corporations, and as such, they’re not taxed the same. REIT distributions can consist of a mix of capital gains, return of capital, and other income, all subject to a different tax treatment. The exact tax breakdown varies from REIT to REIT and generally changes yearly. Investors should consult with tax professionals to understand the specific tax implications of their REIT investment.
- Management Risk: Although REITs are managed by professional real estate managers, poor management decisions can negatively impact REIT performance.
How can I invest in REITs?
Investing in REITs involves purchasing units listed on major stock exchanges or buying units in REIT mutual funds or ETFs. However, you should be aware of the redemption terms of the funds or private vehicles, which can be gated (restricting investor redemption rights) or suspended. Before investing, thorough research and understanding of the underlying assets, management team, and market dynamics are crucial.
Real Estate Investment Trusts can be valuable to a well-diversified investment portfolio. They offer the potential for regular income, diversification, and tax advantages, but they also come with risks that investors should carefully consider.
